I.

The demand curve: “ceteris parabus” in Latin means “other things equal”
a. Movements along vs. shifts in demand:
i. Price changes cause movements along
ii. Other factors will cause shifts in demand:
1. Changes in the prices of related goods (substitutes & complements)
2. Changes in income
3. Changes in tastes
4. Changes in expectations
II. The supply curve:
a. Definition: amount of good or service suppliers will be willing and able to sell at a
particular time & price, ceteris parabus. (upward sloping)
b. Shifts in supply:
i. Changes in input prices (raw material of a final good – intermediate goods)
ii. Changes in number of sellers
iii. Changes in technology
iv. Changes in expectation
III. Market equilibrium:
a. A competitive market is in equilibrium when P has moved to a level where Qd = Qs
i. A competitive market has many buyers and sellers and none is large enough
to individually affect the price
b. Why do markets reach an equilibrium?
i. If prices are too high, there is excess supply (a surplus) and P will go down
ii. If prices are too low, there is excess demand (a shortage) and P will go up
IV. Engle curves:
a. Describes how household expenditure on a particular good or service varies with income
b. Normal vs. inferior goods told by the slope:
i. If slope is positive: normal good because consumption increases with income
ii. If slope is negative: inferior good because consumption decreases when
income increases
iii. An example of a good with both normal & inferior segments: the grilled
cheese sammich
V. Law of Diminishing (Marginal) Returns (aka Law of Increasing Costs):
a. Definition: the decrease in the marginal output of a production process as the amount of
a single factor of production is increased, ceteris parabus. In other words, in all productive
processes, adding more of one factor will at some point yield lower return per unit. At this
point, production cost has increased more than the effiency of input/labor.

b. Average Total Cost of production: Total Cost/Number of Units

Assuming fixed costs are high & labor costs are low: as long as MC is lower than ATC, ATC
decreases
VI. Elasticities:
VII. Price Elasticity of Demand: Short-run vs. long-run:
a. Demand is price inelastic if change in price causes smaller % change in demand. PED <
1
b. Short-run: One year or less
c. Long-run: long enough for consumers or producers to adjust fully to the price change
i. For many goods, D is much more P elastic in the long run than in the short
run:
1. It takes time for people to change consumption habits (coffee)
2. May also depend on the stock of another good that changes slowly
(e.g.: gas goes up, but fuel-efficient cars take a while to be produced)
ii. For other goods, D is more P elastic in the short run:
1. Durable goods (cars, fridges, TVs, etc.): the total stock owned by
customers is relatively large compared to annual production.
Therefore, a small change in D may result in a large change in supply
(or level of purchases)
2. E.g.: fridges price goes up 10% causing Qd -5%, but the current
purchases of new fridges will drop more than 5%. Eventually, ppl’s
fridges will break and number of purchases/owned fridges will be -5%
VIII. Consumer Behavior: 3 steps:
a. Consumer preferences
b. Budget constraints
c. Consumer choices
IX. Consumer Preferences:
a. Market basket: list with specific quantities of one or more goods
b. Three assumptions:
i. Completeness: consumers can compare and rank all possible baskets
ii. Transitivity: if A > B & B > C => A > C (preference consistency)
iii. More is better than less: never satiated/satisfied: more is always better, even
if by just a little
c. Indifference Curves:
i. Represents all combinations of market baskets that provide a consumer with
the same level of satisfaction and utility (A = B = C): moving along the curve,
the consumer feels neither better or worse off (indifferent)
d. Indifference Maps:
i. A combination of all indiference curves at different satisfaction levels (I3 > I2 >
I1 because we get more of both goods as the curves move up/right)
ii. Indifference curves cannot intersect because of the Transitivity assumption
iii. Downward sloping: people face trade-offs, and they’re willing to give up some
of one good for more of another
e. Marginal Rate of Substitution (MRS):
i. Used to quantify this trade-off that people make: how many of one good given
up in exchange for more of another
ii. MRS = max amount of A given up to obtain 1 more of B
f. Diminishing Marginal Rate of Substitution:
i. Convexity: an indifference curve is convex if MRS decreases along the curve
(slope increases/become less negative)
g. Perfect Substitute: (pg. 76)
i. Willingness of a consumer to substitute one for another (orange vs. apple
juice)
ii. Constant slope: -1, -2, etc. (even -6: a six-pack vs. a single can)
h. Perfect complements:
i. Cannot obtain satisfaction without both A & B (left shoe & right shoe)
ii. Indifference curve: shaped as right angles
i. Utility:
i. Numerical score representing the satisfaction that a consumer gets from a
mkt basket
j. Utility Functions:
i. Assigns a level of utility to each market basket
ii. u(A, B) = x of the same value yields the indifference curve
CHAPTER 5 – Uncertainty and Consumer
Behavior

5.1 Describing Risk:

I. Probability:
a. Objective probability: relies on past experience (frequency with which certain events
tend to occur – statistics)
b. Subjective probability: perception that an outcome will occur which varies depending on
different information or abilities to process the same information
II. Expected value:
a. Weighted average of the payoffs or values associated with all possible outcomes
(probability = weight)
b. Measures the central tendency – payoff or value that we would expect on average
c. For two possible outcomes: success = $40/share, failure = $20/share, we have:

Expected value = Pr(success)($40) + Pr(failure)($20)

= (1/4)($40) + (3/4)($20) = $25
d. General function:

E(X) = Pr1X1 + Pr2X2

III. Variability:
a. The extent to which the possible outcomes of an uncertain situation differ

Table 5.1: Income from Sales Jobs

Table 5.1 Outcome 1 Outcome 2 Expected

Pr Income Pr Income Income
Job 1 0.5 2000 0.5 1000 1500
Job 2 0.99 1510 0.01 510 1500

Table 5.2: Deviations from Expected Income

Table 5.2 Outcome 1 Deviation Outcome 2 Deviation

Job 1 2000 500 1000 -500
Job 2 1510 10 510 -990

b. Deviation: difference between expected payoff and actual payoff

c. Variance: Weighted average of squared deviation (σ2):
 σ2 = Pr1*[(X1-E(X))2] + Pr2*[(X2-E(X))2]

Calculating St Dev:

Job 1:` 0.5(5002) + 0.5(5002) = $250,000

Job 2: .99(102) + .01(9902) = $9900

St dev = √σ2 = √259,900

 Risk averse: one who prefers a certain amount of return from a risky investment with the same
expected return.
o Risk premium: the maximum amount that a risk-averse person would pay to avoid taking
a risk
 Risk neutral: one who’s indifferent between a risky investment and the certainty of receiving
return
 Risk-loving consumers would prefer a risky investment with a given expected return to the
certainty of receiving it
 Risk can be reduced by:
o Diversification
o Insurance
o Additional information
 Law of large numbers: while single events are largely unpredictable, the average outcome of
many similar events can be predicted
o LLN enables insurers to provide insurance such that the premiums paid = expected
value of the losses being insured against. We call this actuarially fair.
 Consumer theory in this context:
o Budget line = price of risk
o Indfference curves = attitudes toward risk
 Behavioral economics take into account:
o Reference points
o Endowment effects
o Anchoring
o Fairness considerations
o Deviations from the laws of probability (law of small numbers)

Review questions and exercises (Ch 5):

Review #1: What does it mean to say that a person is risk averse? Why are some people likely to
be risk averse while others are risk lovers?

 A risk-averse person has a diminishing marginal utility of income (MUi) and prefers a certain
income to a gamble with the same expected income. A risk lover has an increasing marginal
utility of income and prefers an uncertain income to a certain income when the expected value
 of the uncertain income equals the certain income. To some extent, a person's risk preferences
are like preferences for different vegetables. They may be inborn or learned from parents or
others, and we cannot easily say why some people are risk averse while others like taking risks.
But there are some economic factors that can affect risk preferences. For example, a wealthy
person is more likely to take risks than a moderately well-off person, because the wealthy
person can better handle losses. Also, people are more likely to take risks when the stakes are
low (like office pools around NCAA basketball time) than when stakes are high (like losing a
house to fire).

Exercise #4: Suppose an investor is concerned about a business choice in which there are three
prospects—the probability and returns are given below:

Probability Return
0.4 $100
0.3 30
0.3 -30

What is the expected value of the uncertain investment? What is the variance?

E(X) = Pr1X1 + Pr2X2

EV = .4(100) + .3(30) + .3(-30) = 40 + 9 – 9 = $40

σ2 = Pr1*[(X1-E(X))2] + Pr2*[(X2-E(X))2]

σ2 = .4(100-40)2 + .3(30-40)2 + .3(-30-40)2 = 1440 + 30 + 1470 = 2940

CHAPTER 6 – PRODUCTION
Concepts:

I. Production Decisions:
a. Cost Constraints:
i. Firms must consider prices of labor, capital and other inputs
ii. Firms want to minimize total production costs partly determined by input prices
iii. As consumers must consider budget constraints, firms must be concerned about
costs of production
b. Input Choices
i. Given input prices and production technology, the firm must choose how much of
each input to use in producing output
ii. Given prices of different inputs, the firm may choose different combinations of
inputs to minimize costs
 1. If labor is cheap, firm may choose to produce with more labor and less
capital
c. If a firm is a cost minimizer, we can also study
i. How total costs of production vary with output
ii. How the firm chooses the quantity to maximize its profits
d. We can represent the firm’s production technology in the form of a production function

II. Production Function:

q = F(K, L)

q = highest Output for a specified combination of inputs

K = capital

L = labor

III. The Short-run vs. Long-run:

a. Short-run: Period when quantities of one or more factors of production cannot be
changed (variable vs. fixed inputs)
b. Long-run: amount of time needed to make all inputs variable

IV. Production with One Variable Input (Labor):

Table 6.1

a. Average = Output/Quantity or Output/Labor input:

APL = q/L
i. Slope = slope of line drawn from the origin to the corresponding point on Total
Output curve
ii. E.g.: at Q = 2, Average = 300 => Slope from [0,0] to [2,300] = 300
b. Marginal = Change in Output/Change in Labor input:
MPL = Δq/ΔL
i. Slope = first derivative of Total Output funtion (or slope of Total Output at that
point)
 Figure 6.1(a)

Figure 6.1(b)

c. Slopes of Product Curve: Whenever the marginal product is greater than the average
product, the average product is increasing & vice versa (pg. 208)
d. Notes on Law of Diminishing Marginal Returns:
i. LDR assumes that all labor unputsare of equal quality, meaning that DR results
from limitations on the use of other fixed inputs (e.g., machinery, working space),
not from declines in worker quality
ii. LDR describes a declining marginal product (not negative returns)

Figure 6.2 – The effect of Technological improvement

V. Production with Two Variable Inputs:
Table 6.4

a. Isoquants: curve that shows all possible combinations of inputs that yield the same
output
i. Aka: equal product curve, production indifferent curve, or constant product curve
b. Isoquant map: graph that shows a number of isoquants
Figure 6.5 – Production isoquants
c. Marginal rate of technical substitution (MRTS): amount by which the input of capital
can be reduced when one extra unit of labor is used, such that Output remains constant
(same as the MRS & always positive)
MRTS = -ΔK/ΔL (q is fixed)

Figure 6.6 – MRTS

As labor increases to replace capital:

i. Labor becomes relatively less productive
ii. Capital becomes relatively more productive
iii. Need less capital to keep output constant
iv. Isoquant becomes flatter
d. Diminishing MRTS:
 i. We assume there is diminishing MRTS:
1. Increasing labor in one unit increments from 1 to 5 results in a decreasing
MRTS from 1 to 1/2
2. Productivity of any one input is limited
ii. Diminishing MRTS occurs because of diminishing returns and implies isoquants
are convex
iii. There is a relationship between MRTS and marginal products of inputs
iv. If we increase labor and decrease capital while keeping output constant:
v. We can see that there will be a decrease in output due to decreased capital
usage, but an equally offsetting increase in output due to the increased labor
usage
1. Additional output from increased use of labor:
(MPL)( ΔL)
2. Reduction in output from decreased use of capital:
(MPK)( ΔK)
3. As we’re keeping output constant by moving along an isoquant, the total
change in output must be zero. Thus:
(MPL )( L)  (MPK )( K)  0
4. Rearranging the equation and we have:
(MPL ) K
  MRTS
( MPK ) L
Therefore, MRTS between two inputs = ratio of MPs of the inputs
e. Isoquants: Two special cases:
i. Perfect substitutions:
Figure 6.7 – Perfect substitutes
 1. MRTS is constant at all points on isoquant
2. Same output can be produced with a lot of capital or a lot of labor or a
balanced mix
ii. Perfect complements: (aka fixed-proportions production function or Leontief PF)
Figure 6.8 – Fixed-proportions PF

1. There is no substitution available between inputs

2. The output can be made with only a specific proportion of capital and
labor
3. Cannot increase output unless increase both capital and labor in that
specific proportion
VI. Returns to Scale:
a. How does a firm decide, in the long run, the best way to increase output?
i. Can change the scale of production by increasing all inputs in proportion
 ii. If double inputs, output will most likely increase but by how much?
b. Rate at which output increases as inputs are increased proportionately
i. Increasing returns to scale: output more than doubles when all inputs are
doubled
1. Larger output associated with lower cost (cars)
2. One firm is more efficient than many (utilities)
3. The isoquants get closer together
Figure 6.10(b)

ii. Constant returns to scale: output doubles when all inputs are doubled
1. Size does not affect productivity
2. May have a large number of producers
3. Isoquants are equidistant apart (equally spaced)
Figure 6.10(a)

iii. Decreasing returns to scale: output less than doubles when all inputs are
doubled
1. Decreasing efficiency with large size
2. Reduction of entrepreneurial abilities
3. Isoquants become farther apart
 c. Returns to scale not necessarily consistent across levels of output. One possibility might
be:
i. There are constant returns to scale for relatively small plants
ii. There are increasing returns to scale for relatively larger plants

VII. Cobb-Douglas Production Function:

[fill up this blank]

Calculating MPL using Cobb-Douglas PF

If β+α=1 , the production function has constant returns to scale.

If β+α > 1 , the production function has increasing returns to scale.

If β+α < 1 , the production function has decreasing returns to scale.

Review questions and exercises (Ch 6):

Review #1: What is a production function? How does a long-run production function differ from
a short-run production function?

A production function represents how inputs are transformed into outputs by a firm. In particular, a
production function describes the maximum output that a firm can produce for each specified
combination of inputs. In the short run, one or more factors of production cannot be changed, so a
short-run production function tells us the maximum output that can be produced with different amounts
of the variable inputs, holding fixed inputs constant. In the long-run production function, all inputs are
variable.
Review #2: Why is the marginal product of labor likely to increase initially in the short run as
more of the variable input is hired? Keyword: specialization

The marginal product of labor is likely to increase initially because when there are more workers, each
is able to specialize in an aspect of the production process in which he or she is particularly skilled. For
example, think of the typical fast food restaurant. If there is only one worker, he will need to prepare the
burgers, fries, and sodas, as well as take the orders. Only so many customers can be served in an
hour. With two or three workers, each is able to specialize, and the marginal product (number of
customers served per hour) is likely to increase as we move from one to two to three workers.
Eventually, there will be enough workers and there will be no more gains from specialization. At this
point, the marginal product will begin to diminish.

Exercise #3: Fill in the gaps in the table below.

Quantity of Total Marginal Product Average Product

Variable Input Output of Variable Input of Variable Input
0 0 __ __
1 225 225 225
2 600 375 300
3 900 300 300
4 1140 240 285
5 1365 225 273
6 1350 —15 225

CHAPTER 7 – COST OF PRODUCTION

I. Measuring Cost: Which Costs Matter?
a. For a firm to minimize costs, we must clarify what is meant by costs and how to measure
them
i. It is clear that if a firm has to rent equipment or buildings, the rent they pay is a
cost
ii. What if a firm owns its own equipment or building?
1. How are costs calculated here?
b. Accounting vs. Economic Costs: Accountants tend to take a retrospective view of firms’
costs, whereas economists tend to take a forward-looking view
i. Accounting Cost: Actual expenses plus depreciation charges for capital
equipment
ii. Economic Cost: Cost to a firm of utilizing economic resources in production,
including opportunity cost
iii. Economic costs distinguish between costs the firm can control and those it
cannot
 1. Concept of opportunity cost plays an important role
2. Economic Cost = Opportunity Cost
iv. Opportunity cost: Cost associated with opportunities that are foregone or the
value of the next best alternative use of a resource. Examples:
1. A firm owns its own building and pays no rent for office space:
a. Does this mean the cost of office space is zero?
b. The building could have been rented instead
c. Foregone rent is the opportunity cost of using the building for
production and should be included in the economic costs of doing
business
2. A person starting their own business must take into account the
opportunity cost of their time
a. Could have worked elsewhere making a competitive salary
3. Accountants and economists often treat depreciation differently as well
c. Although opportunity costs are hidden and should be taken into account, sunk costs
should not. Sunk costs:
i. Expenditure that has been made and cannot be recovered
ii. Should not influence a firm’s future economic decisions
iii. Examples:
1. Firm buys a piece of equipment that cannot be converted to another use
=> Expenditure on the equipment is a sunk cost
a. Has no alternative use so cost cannot be recovered – opportunity
cost is zero
b. Decision to buy the equipment might have been good or bad, but
now does not matter
iv. Prospective Sunk Cost:
1. Firm is considering moving its headquarters
2. A firm paid $500,000 for an option to buy a building
3. The cost of the building is $5 million for a total of $5.5 million
4. The firm finds another building for $5.25 million
5. Which building should the firm buy?
6. The first building should be purchased
7. The $500,000 is a sunk cost and should not be considered in the decision
to buy
8. What should be considered is
a. Spending an additional $5,250,000 or
b. Spending an additional $5,000,000
d. Total Cost (TC or C) can be divided into:
i. Fixed Cost: Does not vary with the level of output
ii. Variable Cost: Cost that varies as output varies
TC = FC + VC
iii. Short time horizon – most costs are fixed
iv. Long time horizon – many costs become variable
e. Fixed vs. Sunk Costs:
 i. Fixed Cost: Cost paid by a firm that is in business regardless of the level of
output
ii. Sunk Cost: Cost that has been incurred and cannot be recovered
iii. Examples:
1. Personal Computers
a. Most costs are variable
b. Largest component: labor
2. Software
a. Most costs are sunk
b. Initial cost of developing the software
iv. Amortization: treating a one-time expenditure as an annual cost spread out over
some number of years (or months/other intervals)
f. Marginal vs. Average Costs:
i. Marginal Cost (MC):
1. The cost of expanding output by one unit
2. Fixed costs have no impact on marginal cost, so it can be written as:
ΔVC ΔTC
MC  
Δq Δq
ii. Average Total Cost (ATC):
1. Cost per unit of output
2. Also equals average fixed cost (AFC) plus average variable cost (AVC)
TC
ATC   AFC  AVC
q
TC TFC TVC
ATC   
q q q

Table 7.1 – A Firm’s Costs

II. Cost in the Short Run:
a. Determinants of Short-run Costs:
i. The rate at which these costs increase depends on the nature of the production
process:
1. The extent to which production involves diminishing returns to variable
factors
ii. Diminishing returns to labor:
1. When marginal product of labor is decreasing
iii. If marginal product of labor decreases significantly as more labor is hired
1. Costs of production increase rapidly
2. Greater and greater expenditures must be made to produce more output
iv. If marginal product of labor decreases only slightly as increase labor
1. Costs will not rise very fast when output is increased
v. Example:
1. Assume the wage rate (w) is fixed relative to the number of workers hired
2. Variable costs is the per unit cost of extra labor times the amount of extra
labor: wL
VC wL
MC  
q q
3. Remembering that
Q
MPL 
L
4. Rearranging the equation
w
MC 
MPL
 5. Therefore: a low marginal product (MPL) leads to a high marginal cost
(MC) and vice versa
6. Consequently (from the table):
a. MC decreases initially with increasing returns
i. 0 through 4 units of output
b. MC increases with decreasing returns
i. 5 through 11 units of output
b. Cost Curves: The following figures illustrate how various cost measures change as
outputs change (Based on Table 7.1)
Figure 7.1 – Cost Curves for a firm

i. Observations:
1. When MC is below AVC, AVC is falling
 2. When MC is above AVC, AVC is rising
3. When MC is below ATC, ATC is falling
4. When MC is above ATC, ATC is rising
5. Therefore, MC crosses AVC and ATC at the minimums
a. The Average-Marginal relationship

ii. The line drawn from the origin to the variable cost curve:
1. Its slope equals AVC
2. The slope of a point on VC or TC equals MC
3. Therefore, MC = AVC at 7 units of output (point A)
III. Cost in the Long Run:
a. Some notes:
i. In the long run a firm can change all of its inputs
ii. In making cost minimizing choices, must look at the cost of using capital and
labor in production decisions
iii. Now: The firms’ long-run cost minimizing decision
iv. Capital is either rented/leased or purchased
1. We will consider capital rented as if it were purchased
v. Assume Delta is considering purchasing an airplane for $150 million
1. Plane lasts for 30 years
2. $5 million per year – economic depreciation for the plane
vi. If the firm had not purchased the plane, it would have earned interest on the
$150 million
vii. Forgone interest is an opportunity cost that must be considered
b. User Cost of Capital: The user cost of capital must be considered
i. The annual cost of owning and using the airplane instead of selling or never
buying it
ii. Sum of the economic depreciation and the interest (the financial return) that
could have been earned had the money been invested elsewhere
iii. User Cost of Capital = Economic Depreciation + (Interest Rate)*(Value of
Capital)
 iv. = $5 mil + (.10)($150 mil – depreciation)
1. Year 1 = $5 million + (.10)($150 million) = $20 million
2. Year 10 = $5 million +(.10)($100 million) = $15 million
v. User cost can also be described as:
1. Rate per dollar of capital, r
2. r = Depreciation Rate + Interest Rate
vi. In our example, depreciation rate was 3.33% and interest was 10%, so
1. r = 3.33% + 10% = 13.33%
c. Cost Minimizing Input Choice:
i. How does a firm select inputs to produce a given output at minimum cost?
Assumptions
1. Two Inputs: Labor (L) and capital (K)
2. Price of labor: wage rate (w)
3. The price of capital
a. r = depreciation rate + interest rate
b. Or rental rate if not purchasing
c. These are equal in a competitive capital market
ii. The Isocost Line
1. A line showing all combinations of L & K that can be purchased for the
same cost
2. Total cost of production is sum of firm’s labor cost, wL, and its capital
cost, rK:
C = wL + rK
C = 30L + 50r
MC = 30/90 = 1/3

3. For each different level of cost, the equation shows another isocost line
4. Rewriting C as an equation for a straight line:
K = C/r - (w/r)L
a. Slope of the isocost:
K
L
 r
w
i. -(w/r) is the ratio of the wage rate to rental cost of capital.
ii. This shows the rate at which capital can be substituted for
labor with no change in cost

[check with ppt & fill up gap]

iii. The Expansion Path and Long Run Costs:

 1. Firm’s expansion path has same information as long-run total cost curve
2. To move from expansion path to LR cost curve
a. Find tangency with isoquant and isocost
b. Determine min cost of producing the output level selected
c. Graph output-cost combination

Figure 7.6 (b) – A Firm’s Long Run Total Cost Curve

Review questions and exercises (Ch 7):

Review #2: The owner of a small retail store does her own accounting work. How would you
measure the opportunity cost of her work?
The economic, or opportunity, cost of doing accounting work is measured by computing the monetary
amount that the owner's time would be worth in its next best use. For example, if she could do
accounting work for some other company instead of her own, her opportunity cost is the amount she
could have earned in that alternative employment. Or if she is a great stand-up comic, her opportunity
cost is what she could have earned in that occupation instead of doing her own accounting work.

Review #8: Assume that the marginal cost of production is greater than the average variable
cost. Can you determine whether the average variable cost is increasing or decreasing?
Explain.

Yes, the average variable cost is increasing. If marginal cost is above average variable cost, each
additional unit costs more to produce than the average of the previous units, so the average variable
cost is pulled upward.:

Exercise #3: A firm has a fixed production cost of $5000 and a constant marginal cost of
production of $500 per unit produced.
a. What is the firm's total cost function? Average cost?
The variable cost of producing an additional unit, marginal cost, is constant at $500, so

VC = 500q, and AVC = VC/q = 500q/q = 500.

Fixed cost is $5000 and therefore average fixed cost is

AFC = 5000/q.
The total cost function is fixed cost plus variable cost or
TC = 5000 + 500q.

Average total cost is the sum of average variable cost and average fixed cost:

ATC = 500 + 5000/q

b. If the firm wanted to minimize the average total cost, would it choose to be very large
or very small? Explain.
The final would choose to be very large because average total cost decreases as q is increased.
As q becomes extremely large, ATC will equal approximately 500 because the average fixed
cost becomes close to zero.

Chapter 6-7 Additional Practice Questions:

Average Total Cost Problem:

Given ATC = 10 + 5Q

a. Is the firm operating in the short run or long run?

b. Find the marginal cost at Q = 10.

Answers:

a. Long run – due to no fixed costs (see below)

b. TC = ATC x Q = 100Q + 5Q2

MC = (dTC/dQ) = 100 + 10Q – remember marginal is a change in the corresponding total!

MC at Q = 10: 100 + 100 = $200

Diminishing Marginal Returns:

If Q is the number of cars washed per hour and L is the number of men employed, a study of an
auto laundry found the following SR relationship:

Q = -0.8 + 4.5L – 0.3L2

Does the law of diminishing returns hold?

Answers:

Marginal Product of Labor: QL = dQ/dL = 4.5 – 0.6L

Rate of change of MPL = QLL = d2Q/dL2 = -0.6

Yes, the rate of change is negative => the law of DR holds

CHAPTER 9 – COMPETITIVE MARKETS

Lerner’s Rules:

In the presence of externalities, be they negative or positive:

MSB = MPB = MPR = MRC = MPC = MSC

Efficiency vs. Equity:

http://www.economicshelp.org/blog/2473/economics/efficiency-vs-equity/

Review Questions (Ch 8):

1. Why would a firm that incurs losses choose to produce rather than shut down?
Losses occur when revenues do not cover total costs. If revenues are greater than variable costs, but
not total costs, the firm is better off producing in the short run rather than shutting down, even though it
is incurring a loss. The reason is that the firm will be stuck will all its fixed cost and have no revenue if it
shuts down, so its loss will equal its fixed cost. If it continues to produce, however, and revenue is
greater than variable costs, the firm can pay for some of its fixed cost, so its loss is less than it would be
if it shut down. In the long run, all costs are variable, and thus all costs must be covered if the firm is to
remain in business.

3. In long-run equilibrium, all firms in the industry earn zero economic profit. Why is this true?

The theory of perfect competition explicitly assumes that there are no entry or exit barriers to new
participants in an industry. With free entry, positive economic profits induce new entrants. As these
firms enter, the supply curve shifts to the right, causing a fall in the equilibrium price of the product.
Entry will stop, and equilibrium will be achieved, when economic profits have fallen to zero.

Some firms may earn greater accounting profits than others because, for example, they own a superior
source of an important input, but their economic profits will be the same. To be more concrete, suppose
one firm can mine a critical input for $2 per pound while all other firms in the industry have to pay $3
per pound. The one firm will have an accounting cost advantage and will report higher accounting
profits than other firms in the industry. But there is an opportunity cost associated with the company's
input use, because other firms would be willing to pay up to $3 per pound to buy the input from the firm
with the superior mine. Therefore, the company should include a $1 per pound opportunity cost for
using its own input rather than selling it to other firms. Then, that firm's economic costs and economic
profit will be the same as all the other firms in the industry. So all firms will earn zero economic profit in
the long run.

Exercise (Ch 8):

4. Suppose you are the manager of a watchmaking firm operating in a competitive market. Your
cost of production is given by C = 200 + 2q2, where q is the level of output and C is total cost.
(The marginal cost of production is 4q; the fixed cost is $200.)

a. If the price of watches is $100, how many watches should you produce to maximize
profit?
Profits are maximized where price equals marginal cost. Therefore, 100 = 4q, or q = 25.
b. What will the profit level be?
Profit is equal to total revenue minus total cost: π = Pq – (200 + 2q2). Thus,

= (100)(25) – (200 + 2(25)2) = $1050.

c. At what minimum price will the firm produce a positive output?

The firm will produce in the short run if its revenues are greater than its total variable costs. The

firm's short-run supply curve is its MC curve above minimum AVC. Here, AVC = VC/q = 2q2/q = 2q

Also, MC = 4q. So, MC is greater than AVC for any quantity greater than 0. This means that the
firm produces in the short run as long as price is positive.
Review Questions (Ch 9):

1. What is meant by deadweight loss? Why does a price ceiling usually result in a deadweight
loss?

Deadweight loss refers to the benefits lost by consumers and/or producers when markets do not
operate efficiently. The term deadweight denotes that these are benefits unavailable to any party. A
price ceiling set below the equilibrium price in a perfectly competitive market will result in a deadweight
loss because it reduces the quantity supplied by producers. Both producers and consumers lose
surplus because less of the good is produced and consumed. The reduced (ceiling) price benefits
consumers but hurts producers, so there is a transfer from one group to the other. The real culprit, then,
and the primary source of the deadweight loss, is the reduction in the amount of the good in the market.

Exercise (Ch 9):

14. You know that if a tax is imposed on a particular product, the burden of the tax is shared
by producers and consumers. You also know that the demand for automobiles is
characterized by a stock adjustment process. Suppose a special 20% sales tax is suddenly
imposed on automobiles. Will the share of the tax paid by consumers rise, fall, or stay the
same over time? Explain briefly. Repeat for a 50-cents-per-gallon gasoline tax.

For products with demand characterized by a stock adjustment process, short-run demand is more
elastic than long-run demand because consumers can delay their purchases of these goods in the
short run. For example, when price rises, consumers may continue using the older version of the
product that they currently own. However, in the long run, a new product will be purchased as the
old one wears out. Thus the long-run demand curve is more inelastic than the short-run one.
Consider the effect of imposing a 20% sales tax on automobiles in the short and long run. The
portion of the tax that will be borne by consumers is given by the pass-through fraction, EJ(Es—
ED). Assuming that the elasticity of supply, Es, is the same in the short and long run, as demand
becomes less elastic in the long run, the elasticity of demand, ED, will become smaller in absolute
value. Therefore the pass-through fraction will increase, and the share of the automobile tax paid by
consumers will rise over time.
Unlike the automobile market, the gasoline demand curve is not characterized by a stock
adjustment effect. Long-run demand will be more elastic than short-run demand, because in the
long run consumers can make adjustments such as buying more fuel-efficient cars and taking
public transportation that will reduce their use of gasoline. As the demand becomes more elastic in
the long run, the pass-through fraction will fall, and therefore the share of the gas tax paid by
consumers will fall over time.

Review (Ch 10):

4. Why might a firm have monopoly power even if it is not the only producer in the market?

A firm can have some monopoly power if its product is differentiated from other firms' products, and
if some consumers prefer its product to other firms' products. A firm might also be located more
conveniently for some consumers. These differences allow the firm to charge a price above its
marginal cost and different from its rivals.
11. What are some sources of monopsony power? What determines the amount of
monopsony power an individual firm is likely to have?
 The individual firm's monopsony power depends on the characteristics of the "buying-side" of the
market. There are three characteristics that enhance monopsony power: (1) the elasticity of market
supply, (2) the number of buyers, and (3) how the buyers interact_ First, if market supply is very
inelastic, then the buyer will enjoy more monopsony power. When supply is very elastic, marginal
expenditure and average expenditure do not differ by much, so price will be closer to the
competitive price. Second, the fewer the number of buyers, the greater the monopsony power.
Third, if buyers are able to collude and/or they do not compete very aggressively with each other,
then each will enjoy more monopsony power.

Exercise (Ch 10):

2. Caterpillar Tractor, one of the largest producers of farm machinery in the world, has hired
you to advise it on pricing policy. One of the things the company would like to know is how
much a 5% increase in price is likely to reduce sales. What would you need to know to help
the company with this problem? Explain why these facts are important.
As a large producer of farm equipment, Caterpillar Tractor has some market power and should
consider the entire demand curve when choosing prices for its products. As their advisor, you
should focus on the determination of the elasticity of demand for the company's tractors. There are
at least four important factors to be considered. First, how similar are the products offered by
Caterpillar's competitors? If they are close substitutes, a small increase in price could induce
customers to switch to the competition. Second, how will Caterpillar's competitors respond to a
price increase? If the other firms are likely to match Caterpillar's increase, Caterpillar's sales will not
fall nearly as much as they would were the other firms not to match the price increase. Third, what
is the age of the existing stock of tractors? With an older population of tractors, farmers will want to
replace their aging stock, and their demands will be less elastic. In this case, a 5% price increase
induces a smaller drop in sales than would occur with a younger stock of tractors that are not in
need of replacement. Finally, because farm tractors are a capital input in agricultural production,
what is the expected profitability of the agricultural sector? If farm incomes are expected to fall, an
increase in tractor prices would cause a greater decline in sales than would occur if farm incomes
were high.

Profit Maximization in noncompetitive markets:

The demand curve facing a bicyle manufacturer is given by (P = price/unit; Q = quantity)

P = 1000 – 3Q
The total costs (TC) of producing bikes are given by

TC = 100 + 2Q2
1. Cicle one:
a. The firm is:
i. Noncompetitive because AR ≠ MR
ii. Competitive AR = MR?
b. The firm is operating in:
i. Short run as there are fixed costs
ii. Long run there are no fixed costs

2. Find the firm’s maximum/equilibrium profits

TC = 100 + 2Q2 TR = 1000Q – 3Q2
dTC/dQ = MC = 4Q dTR/dQ = MR = 1000 – 6Q
 P = 1000 – 3(100) TC = 100 + 2(100)2
P = $700 = 100 + 20000 = 20100
MR = MC
 1000 – 6Q = 4Q Profit = P(Q) – TC = 700(100) – 20100
1000 = 10Q = $49,900
100 = Q Comparing monopoly and
competition

Review (Ch 11):

1. Suppose a firm can practice perfect first-degree price discrimination. What is the lowest
price it will charge, and what will its total output be?
When a firm practices perfect first-degree price discrimination, each unit is sold at the reservation
price of each consumer (assuming each consumer purchases one unit). Because each unit is sold
at the consumer's reservation price, marginal revenue is simply the price at which each unit is sold,
and thus the demand curve is the firm's marginal revenue curve. The profit-maximizing output is
therefore where MR = MC, which is the point where the marginal cost curve intersects the demand
curve. Thus the price of the last unit sold equals the marginal cost of producing that unit, and the
firm produces the perfectly competitive level of output.

13. How does tying differ from bundling? Why might a firm want to practice tying?
Tying involves the sale of two or more goods or services that must be used as complements.
Bundling can involve complements or substitutes. Tying allows the firm to monitor customer
demand and more effectively determine profit-maximizing prices for the tied products. For example,
a microcomputer firm might sell its computer, the tying product, with minimum memory and a
unique architecture, then sell extra memory, the tied product, above marginal cost.

Price Discrimination: Negative relation between price and the price elasticity of demand
 $

Dead weight loss

Ch 11: Price
Competitive Firm (P = MC) Discrimination.pdf
Keywords: demand
Economic Profit: MC (average revenue)
functions, TC function for
Monopoly takes this production, Lerner index,
Monopoly
portion of consumer TR = PQ, MR = (dTR/dQ),
surplus as profit. MC = dTC/dQ
MR = MC
Review (Ch 12):
D
1. What are the
0 Q characteristics of a
monopolistically
competitive market? What
happens to the
equilibrium price and
MR quantity in such a market
if one firm introduces a
new, improved product?
Monopoly: Price is higher but Quantity is lower. The two primary
characteristics of a
Competitive: Price is lower but Quantity is higher. monopolistically competitive
market are that (1) firms
compete by selling
differentiated products that are highly, but not perfectly, substitutable and (2) there is free entry and
exit from the market. When a new firm enters a monopolistically competitive market or one firm
introduces an improved product, the demand curve for each of the other firms shifts inward,
reducing the price and quantity received by those incumbents. Thus, the introduction of a new
product by a firm will reduce the price received and quantity sold of existing products.

Exercise (Ch 12):

1. Suppose all firms in a monopolistically competitive industry were merged into one large
firm. Would that new firm produce as many different brands? Would it produce only a single
brand? Explain.
Monopolistic competition is defined by product differentiation. Each firm earns economic profit by
distinguishing its brand from all other brands. This distinction can arise from underlying differences
in the product or from differences in advertising. If these competitors merge into a single firm, the
resulting monopolist would not produce as many brands, since too much brand competition is
internecine (mutually destructive). However, it is unlikely that only one brand would be produced
after the merger. Producing several brands with different prices and characteristics is one method
of splitting the market into sets of customers with different tastes and price elasticities. The
monopolist can sell to more consumers and maximize overall profit by producing multiple brands
and practicing a form of price discrimination.

Review (Ch 14):

2. Why might a labor supply curve be backward bending?

 A backward-bending supply curve for labor may occur when the income effect of an increase in the
wage rate dominates the substitution effect. Individuals make labor supply decisions by choosing
the most satisfying combination of income (with which to consume goods and services) and leisure.
With a larger wage, the individual can afford to work fewer hours: the income effect. But as the
wage rate increases, the value of leisure time (the opportunity cost of leisure) increases, thus
inducing the individual to consume less leisure and work longer hours: the substitution effect.
Because the two effects work in opposite directions, the labor supply curve is backward bending if
the income effect triggered by a higher wage is greater than the substitution effect of the higher
wage.
6. What happens to the demand for one input when the use of a complementary input
increases?
When the demand for a complementary input increases, the demand for a given input will also
increase

More Concepts (Ch 10):

Concentration ration:

• One measure the degree of competition in an industry is its concentration ratio.

• An industry’s concentration ration is the percentage market share of the top firms in the industry.

• The concentration ratio of the “n” top firms is:

CRn = (Total Sales of the top “n” Firms / Total Industry’s Sales)x100
Monopoly vs. Perfect competition & more Ch 10 stuff

Monopsony’s Profit Maximization

Example problem & Oligopoly & Graphs

Herfindahl index & more Concentration ratios/Collusions

PPF
Normal, Inferior, Giffen goods

ALL CHAPTERS OUTLINE

Ch 2:

2.1 Supply and Demand

2.2 The Market Mechanism

2.3 Changes in Market Equilibrium

2.4 Elasticities of Supply and Demand

2.5 Short-Run versus Long-Run Elasticities

2.6 Understanding and Predicting the Effects of Changing Market Conditions

 2.7 Effects of Government Intervention—Price Controls
Ch 3:

3.1 Consumer Preferences

3.2 Budget Constraints

3.3 Consumer Choice

3.4 Revealed Preference

3.5 Marginal Utility and Consumer Choice

3.6 Cost-of-Living Indexes

Ch 4:

4.1 Individual Demand

4.2 Income and Substitution Effects
4.3 Market Demand

4.4 Consumer Surplus

4.5 Network Externalities
4.6 Empirical Estimation of Demand

Ch 5:

5.1 Describing Risk

5.2 Preferences Toward Risk

5.3 Reducing Risk
5.4 The Demand for Risky Assets
5.5 Behavioral Economics

Ch 6:
6.1 The Technology of Production

6.2 Production with One Variable Input (Labor)

6.3 Production with Two Variable Inputs

6.4 Returns to Scale

Ch 7:

Measuring Cost: Which Costs Matter?

Cost in the Short Run
 Cost in the Long Run
Long-Run Versus Short-Run Cost Curves
Production with Two Outputs:
Economies of Scope

Ch 8:

Perfectly Competitive Markets

Profit Maximization

Marginal Revenue, Marginal Cost, and Profit Maximization

The Competitive Firm

Short Run Production & Supply Curve

Long Run Competitive Equilibrium

Profits vs. Losses

Zero Profit
Ch 9:
9.1 Evaluating the Gains and Losses from Government Policies—Consumer and Producer
Surplus

9.2 The Efficiency of a Competitive Market

9.3 Minimum Prices

9.4 Price Supports and Production Quotas

9.5 Import Quotas and Tariffs

9.6 The Impact of a Tax or Subsidy

Ch 10:
10.1 Monopoly
10.2 Monopoly Power

10.3 Sources of Monopoly Power

10.4 The Social Costs of Monopoly Power

10.5 Monopsony
10.6 Monopsony Power

10.7 Limiting Market Power: The Antitrust Laws

Ch 11:
 11.1 Capturing Consumer Surplus
11.2 Price Discrimination

11.3 Intertemporal Price Discrimination and Peak-Load Pricing

11.4 The Two-Part Tariff

11.5 Bundling
11.6 Advertising

Ch 12:
12.1 Monopolistic Competition

12.2 Oligopoly

12.3 Price Competition

12.4 Competition versus Collusion:
The Prisoners’ Dilemma

12.5 Implications of the Prisoners’ Dilemma for Oligopolistic Pricing

12.6 Cartels
Ch 13:

13.1 Gaming and Strategic Decisions

13.2 Dominant Strategies

13.3 The Nash Equilibrium Revisited

13.4 Repeated Games
13.5 Sequential Games
13.6 Threats, Commitments, and Credibility

13.7 Entry Deterrence

13.8 Auctions